The U.S. Court of Appeals for the Fourth Circuit affirmed the lower court ruling in the case Public Employees Retirement Association of Colorado; Generic Trading of Philadelphia, LLC v. Deloitte & Touche, LLP that Deloitte defendants lacked the necessary scienter to conclude that they knowingly or recklessly perpetrated a fraud on Ahold’s investors.

This class action securities fraud lawsuit arose out of improper accounting by Royal Ahold N.V., a Dutch corporation, and U.S. Foodservice, Inc. (USF), a Maryland-based Ahold subsidiary. The misconduct of Ahold and USF was not disputed in this appeal. The main issue is the liability of Ahold’s accountants, Deloitte & Touche LLP (Deloitte U.S.) and Deloitte & Touche Accountants (Deloitte Netherlands), for their alleged role in the fraud perpetrated by Ahold and USF. Under the Private Securities Litigation Reform Act of 1995 (PSLRA), plaintiffs must plead facts alleging a “strong inference” that the defendants acted with the required scienter. As explained by the Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., a strong 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.”

The Appeals Court found that Deloitte, like the plaintiffs, were victims of Ahold’s fraud rather than its enablers. In its decision, the court relied on the PSLRA and the decision in Tellabs. Circuit Judge Wilkinson wrote the conclusion for the court.¹ The court ruling will be explained later on.

ERISA Class Action Settlement

Class action lawsuits are common in cases such as Ahold where dozens of separate private class action securities are combined. In this case the Employee Retirement Income Security Act (ERISA) of 1974 actions were filed against Ahold, Deloitte, and other defendants. On June 18, 2003, the Judicial Panel on Multidistrict Litigation transferred these actions to the U.S. District Court for the District of Maryland, In re Royal Ahold N.V. Securities & “ERISA” Litigation. Following the certification of the class action lawsuit, the U.S. District Court in Maryland ruled in favor of the ERISA plaintiffs on November 2, 2006, and awarded them $1.1 billion in the securities fraud case against Royal Ahold.²

Summary of Accounting Fraud

Beginning in the 1990s, and continuing until 2003, Ahold and USF perpetrated frauds that led it to overstate its earnings on financial reports significantly: The frauds included:

• Ahold improperly “consolidated” the revenue from a number of joint ventures (JVs) with supermarket operators in Europe and Latin America. That is, for accounting purposes, Ahold treated these JVs as if it fully controlled them—and thus treated all revenue from the ventures as revenue to Ahold—when in fact, Ahold did not have a controlling stake. Under Dutch and U.S. GAAP,3 Ahold should have consolidated only the revenue proportionally to Ahold’s stake in the ventures.

• USF falsely reported its income from promotional allowances (PAs). Also known as vendor rebates, PAs are payments or discounts that manufacturers and vendors provide to retailers like USF to encourage the retailers to promote the manufacturers’ products. To increase its stated income, USF prematurely recognized income from PAs and inflated its reported PA income beyond amounts actually received.

• On February 24, 2003, Ahold announced that its earnings for fiscal years 2001 and 2002 had been overstated by at least $500 million as a result of the fraudulent accounting for promotional allowances at USF, and that Ahold would be restating revenues because it would cease treating the joint ventures as fully consolidated. After this announcement, Ahold common stock trading on the Euronext stock exchange4 and Ahold American Depositary Receipts5 trading on the NYSE lost more than 60 percent of their value. Subsequent to the February 2003 announcement, Ahold made further restatements to its earnings totaling $24.8 billion in revenues and approximately $1.1 billion in net income.

Ahold Fraud—Joint Ventures

With respect to the JV fraud, both Deloittes advised Ahold on the consolidation of the joint ventures. Five joint ventures were at issue in this litigation: JMR, formed in August 1992; Bompreço, formed in November 1996; DAIH, formed in January 1998; Paiz-Ahold, formed in December 1999; and ICA, formed in February 2000. Ahold had a 49 percent stake in JMR and a 50 percent share of each of the other ventures at their respective times of formation. Prior to Ahold’s entering into the first joint venture, Deloitte Netherlands and Deloitte U.S. gave Ahold advice about revenue consolidation under Dutch and U.S. GAAP. A memo explained that control of a joint venture is required for consolidation of the venture’s revenue and discussed what situations are sufficient to demonstrate control. The memo indicated that control could be shown by a majority voting interest, a large minority voting interest under certain circumstances, or a contractual arrangement.

Ahold began consolidating the joint ventures as they were formed. The various JV agreements did not indicate that Ahold controlled the ventures. For example, the JMR joint venture agreement specified that decisions would be made by a board of directors, “deciding unanimously,” and that the board would consist of three members appointed by Ahold and four members appointed by JMH, Ahold’s partner in the venture. However, Ahold represented to Deloitte Netherlands that it nonetheless possessed the control requisite for consolidation. Deloitte Netherlands initially accepted these representations for the consolidation of JMR and Bompreço. But as consolidation continued, Deloitte became concerned that Ahold lacked the control necessary to consolidate these first two joint ventures.

On August 24, 1998, Deloitte Netherlands partner John van den Dries sent a letter to Michiel Meurs, Ahold’s chief financial officer (CFO), advising him that Ahold’s representations of control would no longer suffice—that Ahold would need to produce more evidence of control in order to justify continuing consolidation of joint venture revenue under U.S. GAAP, and that without such evidence, a financial restatement would be required. In response to Deloitte Netherlands’s requests, Ahold drafted a “control letter” addressed to BompreçoPar S.A., its partner in the Bompreço joint venture. The letter stated that the parties agreed that if they were unable to reach a consensus on a particular issue, “Ahold’s proposal to solve that issue will in the end be decisive.” After reviewing the draft letter, Deloitte Netherlands advised Ahold that if countersigned by the JV partner, the letter would be sufficient evidence to consolidate the venture. The letter was signed by Ahold and BompreçoPar in May 1999. By late 2000, Ahold had obtained similar countersigned control letters for the ICA, DAIH, and Paiz-Ahold joint ventures. Based on these letters and other evidence, Deloitte Netherlands concluded that consolidation was appropriate. However, in October 2002, Deloitte learned of a “side letter” sent to Ahold in May 2000 by one of Ahold’s ICA joint venture partners, Canica. The letter stated that Canica did not agree with the interpretation of the shareholder agreement stated in the ICA control letter.

At this point, Deloitte Netherlands and Deloitte U.S. began trying to get Ahold to obtain an amendment to the shareholder agreement in order to justify ongoing consolidation. At a February 14, 2003, meeting, Deloitte Netherlands and Deloitte U.S. told Ahold that Ahold lacked the necessary control for consolidation. On February 22, 2003, Ahold revealed to Deloitte Netherlands side letters contradicting the Bompreço, DAIH, and Paiz-Ahold control letters. Two days later, Ahold announced that it had consolidated its joint ventures improperly and would be restating its revenues.

USF Fraud—Promotional Allowances

Ahold acquired USF in early 2000. Prior to the acquisition, Deloitte U.S. participated in Ahold’s due diligence on USF. In a February 2000 memo, Deloitte U.S. noted that USF’s internal system for recording promotional allowances received was weak because it heavily relied on vendors’ figures, and that the system could “easily result in losses and in frauds.” Deloitte U.S. also noted in the memo that USF’s use of value added service providers, special-purpose entities that bought products from vendors and then resold them to USF for a higher price, needed to be evaluated for their “tax and legal implications and associated business risks.”

After Ahold’s acquisition of USF was finalized, Deloitte U.S. became USF’s external auditor. When performing an opening balance sheet audit of USF, Deloitte U.S. discovered that a USF division in Buffalo, New York, had been fraudulently accounting for PA income. This fraud required a restatement of $11 million of PA income. USF also downwardly adjusted its income by $90 million as a result of Deloitte U.S.’s advice that it be less aggressive in its method for recognizing PA income. USF used at interim periods a method known as the “PA recognition rate” to estimate promotional allowance income, in which PAs were estimated as a percentage of USF’s total sales. The rate used by USF was 4.58 percent at the time of Ahold’s acquisition of USF, but it rose as high as 8.51 percent in 2002. When USF booked final numbers, Deloitte U.S. in its audits tested USF’s recognition of PAs by requesting written confirmation of PA amounts from vendors and by performing cash receipt tests. Using this confirmation process, Deloitte U.S. was able to test between 65 and 73 percent of PA receivables in its audits for 2000 and 2001.

Auditing Issues

Because USF lacked an internal auditing department, in April 2000, Ahold hired Deloitte U.S. to perform internal auditing services at USF. The internal auditors did not report to the Deloitte U.S. external auditors.⁶ Instead, they reported initially to Ahold USA’s internal audit director and, later, to USF’s internal audit director after he was hired. The audit was managed by Jennifer van Cleave under the supervision of Patricia Grubel, a Deloitte U.S. partner. One of the internal audit’s objectives was to determine whether USF’s tracking of PAs was adequate. In van Cleave’s attempt to verify USF’s PA numbers, she requested a number of documents from USF management, including vendor contracts. Management refused to produce a number of the requested documents. Several members of management also refused to meet with van Cleave when she asked to conduct exit meetings. Van Cleave was thus unable to complete all the audit’s objectives.

In a February 5, 2001, draft report, van Cleave described how management’s failure to produce requested documents resulted in her inability to complete some of the goals of the audit. Grubel instructed van Cleave to soften the report’s language, and the version submitted to Michael Resnick, director of USF’s Internal Audit Department, simply stated that Deloitte U.S. “was unable to obtain supporting documentation for some of the promotional allowance sample items,” without more specifically detailing management’s failures and lack of cooperation.

In its February 2003 external audit for 2002, Deloitte U.S. discovered through the PA confirmation process that USF had been inflating its recorded PA income. An investigation ensued. Ultimately, USF’s former chief marketing officer (CMO), Mark Kaiser, was convicted on all counts of a federal indictment that alleged that he had induced USF’s vendors to report PA income amounts and receivable balances falsely to Deloitte U.S., and that he had concealed the existence of written contracts with USF vendors from Deloitte U.S. Two other USF executives pled guilty to federal securities fraud charges; in their plea statements, they admitted that USF lied to and deceived Deloitte U.S., and that they induced vendors to sign false audit confirmation letters that falsely overstated PA payments. In addition, 17 individuals associated with USF vendors pled guilty to various charges and admitted that they signed false audit confirmation letters in order to conceal the PA fraud from Deloitte U.S.

PSLRA: Fraud and Scienter

In passing the PSLRA in 1995, Congress imposed heightened pleading requirements for private securities fraud actions. As a general matter, heightened pleading is not the norm in federal civil procedure. Frequently stated reasons include protecting defendants’ reputations from baseless accusations, eliminating unmeritorious suits that are brought only for their nuisance value, discouraging fishing expeditions brought in the slight hope of discovering a fraud, and providing defendants with detailed information in order to enable them to defend effectively against a claim. When “alleging fraud or mistake,” plaintiffs “must state with particularity the circumstances constituting fraud or mistake.”

The PSLRA imposed a number of requirements designed to discourage private securities actions lacking merit. Among them is the requirement that in a private securities action “in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission . . . , state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” Complaints that do not plead scienter adequately are to be dismissed.

Because the PSLRA did not define “a strong inference,” the courts of appeals disagreed on how much factual specificity plaintiffs must plead in private securities actions. The Supreme Court resolved that issue in Tellabs, in which the Court prescribed the following analysis for Rule 12(b)(6) motions to dismiss Section 10(b) actions:

• First, courts must, as with any motion to dismiss for failure to plead a claim on which relief can be granted, accept all factual allegations in the complaint as true.

• Second, courts must consider the complaint in its entirety, as well as other sources that courts ordinarily examine, when ruling on Rule 12(b) motions to dismiss. The inquiry, as several Courts of Appeals have recognized, is whether all the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard.

• Third, in determining whether the pleaded facts give rise to a “strong” inference of scienter, the court must take into account plausible opposing inferences. The strength of an inference cannot be decided in a vacuum. The inquiry is inherently comparative. The inference of scienter must be more than merely “reasonable” or “permissible”—it must be cogent and compelling, thus strong in light of other explanations.

Legal Reasoning

The “strong inference” requirement and the comparative analysis of inferences still leave unanswered the question of exactly what state of mind satisfies the scienter requirement of a 10b-5 action. In Ernst & Ernst v. Hochfelder,⁷ the Supreme Court held that a plaintiff must show that the defendant possessed the “intent to deceive, manipulate, or defraud” in an action brought under Rule 10b-5 of the Securities and Exchange Act of 1934. However, the Court never made clear what mental state suffices to meet this requirement. (“We need not address here the question whether, in some circumstances, reckless behavior is sufficient for civil liability under Rule 10b-5.”). The U.S. Court of Appeals held in Ottman v. Hanger Orthopedic Group, Inc. that “a securities fraud plaintiff may allege scienter by pleading not only intentional misconduct, but also recklessness.”⁸ The court defined a reckless act as one “so highly unreasonable and such an extreme departure from the standard of ordinary care as to present a danger of misleading the plaintiff to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it” (quoting Phillips v. LCI Int’l, Inc.(.⁹ A showing of mere negligence, however, will not suffice to support a 10(b) claim.¹⁰

Thus, the court ruled, the question is whether the allegations in the complaint, viewed in their totality and in light of all the evidence in the record, allow us to draw a strong inference, at least as compelling as any opposing inference, that the Deloitte defendants either knowingly or recklessly defrauded investors by issuing false audit opinions in violation of Rule 10b-5(b) or 10b-5(a) and (c). On the other hand, if it found the inference that defendants acted innocently, or even negligently, more compelling than the inference that they acted with the requisite scienter, it must affirm the lower court’s ruling. Plaintiffs must show that defendants actually made a misrepresentation or omission in their audit opinions on which investors relied.

In light of the foregoing standards, the court considered first the JV fraud. The plaintiffs alleged that Deloitte U.S. and Deloitte Netherlands allowed Ahold to consolidate the joint ventures despite knowing, or being reckless with regard to the risk, that Ahold lacked the control required for consolidation. The thrust of their argument was that the control letters and Ahold’s oral representations were insufficient evidence of control under Dutch and U.S. GAAP. Thus, they argued, the defendants were complicit in the fraud. According to the plaintiffs, the secret side letters, in which the JV partners contradicted Ahold’s interpretations of the JV agreements in the control letters, were irrelevant because the control letters themselves did not amend the JV agreements. The plaintiffs’ arguments did not provide a basis for a strong inference that either Deloitte U.S. or Deloitte Netherlands acted knowingly or recklessly in relation to the JV fraud. The most plausible inference that one can draw from the fact that Ahold concealed the side letters from its accountants is that the accountants were uninvolved in the fraud. Ahold produced letters attesting to Ahold’s control countersigned by Ahold’s partners for the ICA, Bompreço, DAIH, and Paiz-Ahold joint ventures at the Deloitte defendants’ request, all the while concealing the side letters from those same defendants. These facts led to a strong inference that the Deloitte defendants were attempting to ensure that Ahold had sufficient control over the joint ventures for consolidation and that Ahold was determined to prevent them from discovering otherwise. With perfect hindsight, one might posit that the defendants should have required stronger evidence of control from Ahold. Indeed, as the district court noted, it may have been negligent for the defendants to accept as the only evidence of control Ahold’s repeated representations that it controlled JMR, the one joint venture for which Ahold never produced a control letter.¹¹ Nonetheless, the evidence as a whole leads to the strong inference that defendants were deceived by their clients into approving the consolidation. Ahold would not have needed to go out of its way to produce false evidence of control had Deloitte been complicit in the fraud, or had they been so reckless in their duties that their audit “amounted to no audit at all,” as the Southern District of New York has described the standard in SEC v. Price Waterhouse.¹²

To establish a strong inference of scienter, plaintiffs must do more than merely demonstrate that defendants should or could have done more. They must demonstrate that Deloitte was either knowingly complicit in the fraud, or so reckless in its duties as to be oblivious to malfeasance that was readily apparent. The inference that we find most compelling based on the evidence in the record is not that the defendants were knowingly complicit or reckless, but that they were deceived by their client’s repeated lies and artifices. Perhaps their failure to demand more evidence of consolidation was improper under accounting guidelines, but that is not the standard, which “requires more than a misapplication of accounting principles.”¹³

The court then examined the PA fraud. The plaintiffs argued that Deloitte U.S. was knowingly complicit in the fraud when it ignored several red flags, including USF’s lack of internal controls to track PA income and USF management’s obstruction of the internal audit and the facts and the circumstances of USF CFO Ernie Smith’s resignation. With respect to USF’s problems with tracking income with PAs, it is not the case that Deloitte U.S. simply ignored the weak internal controls, as the plaintiffs alleged. Rather, Deloitte U.S. raised this issue numerous times with Ahold and USF management.

Deloitte U.S. designed a confirmation process to verify USF’s reported PA income in which it contacted third-party vendors and received letters from them confirming PA amounts. The plaintiffs described the confirmation process as one that “confirmed nothing.” Yet instead of merely relying on USF representations, as the plaintiffs asserted, Deloitte U.S. obtained corroboration from vendors for the figures provided by USF. Deloitte U.S. would not have attempted to verify USF’s figures with third parties if it were complicit in the scheme, nor can it be said that it was anything but proper to attempt to check the accuracy of representations made by USF management.

The plaintiffs attempted to suggest that the confirmation process was unsound because, for example, Deloitte U.S. accepted confirmation letters via fax and the letters were sent to brokers or sale executives instead of financial officers. But even if the confirmation process was somewhat flawed—which the defendants contested—the larger fact remains that the PA fraud went undetected initially only because USF and its vendors conspired to lie to Deloitte U.S. and to conceal important documents. Indeed, it was Deloitte U.S.’s confirmation process itself that ultimately revealed the fraud. In the course of the 2002 audit, Deloitte U.S. learned in early 2003 from a vendor from which it had requested PA confirmations that employees had signed inaccurate confirmation letters.

Shortly thereafter, Ahold authorized an internal investigation that revealed the extent of the fraud. No doubt it would have been better had the fraud been discovered earlier, but the strongest inference that one can draw from the evidence is that the fraud initially went undetected because of USF’s collusion with the vendors, not because of wrongdoing by Deloitte U.S. As to the internal audit, the internal auditors reported not to the Deloitte U.S. external auditors but to USF, as was consistent with professional standards.¹⁴

The rest of the supposed red flags pointed to by the plaintiffs also failed to create a strong inference of scienter. With respect to the plaintiffs’ allegations that Smith told Deloitte U.S. about the vendor rebate fraud, the district court twice concluded that this claim had no support in the record, and we see no reason to disagree with its conclusion. The plaintiffs alleged that facts like the high CFO turnover at USF and USF’s rapid growth should have alerted Deloitte U.S. that there was fraud afoot, but they failed to explain why this was the only conclusion that Deloitte could make.

Conclusion

“Seeing the forest as well as the trees is essential.” With respect to both frauds, the plaintiffs pointed to ways that the defendants could have been more careful and perhaps discovered the frauds earlier. But the plaintiffs could not escape the fact that Ahold and USF went to considerable lengths to conceal the frauds from the accountants and that it was the defendants that ultimately uncovered the frauds. The strong inference to be drawn from this fact is that Deloitte U.S. and Deloitte Netherlands lacked the requisite scienter and instead were deceived by Ahold and USF. That inference is significantly more plausible than the competing inference that defendants somehow knew that Ahold and USF were defrauding their investors.

The court reiterated that it is not an accountant’s fault if its client actively conspires with others in order to deprive the accountant of accurate information about the client’s finances. It would be wrong and counter to the purposes of the PSLRA to find an accountant liable in such an instance. The court concluded that it had found no version of the facts that would create a strong inference that the Deloitte defendants had the scienter required for a cause of action under Section 10(b); the district court rightly denied the plaintiffs’ motion for leave to amend their complaint.

Questions

1. In most of the cases in this book, the auditors have been taken to task by the courts for failing to follow generally accepted auditing standards (GAAS) and violating their ethical and professional responsibilities. The Royal Ahold case is different because the court essentially found that Deloitte should not be held liable for the efforts of the client to deprive the auditors of accurate information needed for the audit and masking the true nature of other evidence. Still, the facts of the case do raise questions about whether Deloitte compromised its ethical and professional responsibilities in accepting evidence and explanations provided by the client for the joint venture and promotional allowance transactions. Identify those instances and explain why you believe ethical and professional standards may have been violated.

2. Evaluate the decisions made by Deloitte from an ethical reasoning perspective. Be sure to consider the effects of its decisions on the stakeholders.

3. A shareholder may file a securities fraud claim in federal court to recover damages sustained as a result of a financial fraud. Before the PSLRA, plaintiffs could file a lawsuit simply because a stock price changed significantly and hope that the discovery process would reveal potential fraud. After the PSLRA, plaintiffs were required to bring forth particular fraudulent statements made by the defendant, to allege that the fraudulent statements were reckless or intentional and to prove that they suffered a financial loss as a result of the alleged fraud. The Ahold case is an example of how the courts have, sometimes, ruled more liberally with respect to auditors’ legal obligations since the passage of the PSLRA. In the wake of Enron, WorldCom, Adelphia, and other high profile securities frauds, critics suggest that the law made it too easy to escape liability for securities fraud and thus created a climate in which frauds are more likely to occur. Comment on that statement with respect to the fraud at Royal Ahold.

Optional Question

4. Explain the legal liability of auditors under SEC regulations and the Telltabs ruling relied on by the Court. Include in your discussion how scienter is determined. Do you agree with the commission’s conclusion that the Deloitte auditors did not violate their legal obligations to shareholders? Why or why not?

¹U.S. Court of Appeals for the Fourth Circuit, Public Employees Retirement Association of Colorado; Generic Trading of Philadelphia, LLC v. Deloitte & Touche, LLP, January 5, 2009; www.pacer.ca4.uscourts.gov/opinion.pdf/071704.P.pdf.

²In Re Royal Ahold N.V. Securities & ERISA Litigation., 461 F.Supp.2d 383 (2006), Available at http://www.leagle.com/xmlResult.aspx?xmldoc=2006844461FSupp2d383_1796.xml.

³Starting in 2005, members of the European Union (EU), including the Netherlands, adopted International Financial Reporting Standards (IFRS) as the only acceptable standards for EU companies when filing statements with securities regulators in the EU.

⁴NYSE Euronext is the result of a merger on April 4, 2007, between the NYSE and stock exchanges in Paris, Amsterdam, Brussels, and Lisbon, as well as the NYSE Liffe derivatives markets in London, Paris, Amsterdam, Brussels, and Lisbon. NYSE Euronext is a U.S. holding company that operates through its subsidiaries, and it is a listed company. NYSE Euronext common stock is dually listed on the NYSE and Euronext Paris under the symbol “NYX.”

⁵An American Depositary Receipt (ADR) represents ownership in the shares of a non-U.S. company and trades in U.S. financial markets. The stock of many non-U.S. companies trade on U.S. stock exchanges through the use of ADRs. ADRs enable U.S. investors to buy shares in foreign companies without the hazards or inconveniences of cross-border and cross-currency transactions. ADRs carry prices in U.S. dollars, pay dividends in U.S. dollars, and can be traded like the shares of U.S.-based companies.

⁶Under the professional standards then in effect, an auditing firm could provide both internal and external auditing services to the same client. The Sarbanes-Oxley Act of 2002 (SOX) subsequently prohibited internal audit services for external audit clients because of independence concerns.

⁷U.S. Supreme Court, Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).

⁸U.S. Court of Appeals, Ottman v. Hanger Orthopedic Group, Inc., 353 F.3d 338, 344 (4th Cir. 2003).

⁹U.S. Court of Appeals, Phillips v. LCI Int’l, Inc., 190 F.3d 609, 621 (4th Cir. 1999).

¹⁰Ernst & Ernst v. Hochfelder.

¹¹U.S. Court of Appeals, In re Royal Ahold, 351 F.Supp. 2d.

¹²SEC v. Price Waterhouse, 797 F.Supp. 1217, 1240 (S.D.N.Y. 1992) [citing McLean v. Alexander, 599 F.2d 1190, 1198 (3d Cir. 1979)].

¹³SEC v. Price Waterhouse.

¹⁴Institute of Internal Auditors, Standards for the Professional Practice of Internal Auditing, Statement on Internal Auditing Standards 1–18.